Monday, 30 November 2015

To
tackle Egypt’s currency crisis, the authorities need to address the root cause of
the problem: declining exports volume.

The new governor of
the Central Bank of Egypt, Tarek Amer, whose
term only began on 27 November, faces an immediate currency crisis. The crisis
manifests itself through downward pressures on the Egyptian pound, a shortage
of foreign currency and a burgeoning black market. The government is trying to solve
this problem by raising foreign currency, either through a
loan from the World Bank or investments from Saudi Arabia. But this is
merely a short-term fix. The authorities need to address the root cause of the crisis,
which is the decline in Egyptian exports volume since 2008. Here is why.

1. The value of a
country’s exports relative to imports is an important determinant of the price
of its currency. More exports imply higher demand for the country’s currency, leading
to an appreciation. Conversely, more imports typically lead to a depreciation.

2. Egypt has almost
always imported more than it exported, but the gap in the early 2000s was small
enough to be filled by the stable inflow of foreign currency remittances from
Egyptians abroad. However, this gap began to widen and, since 2008, became too
large to be offset by transfers from the Egyptian diaspora. Successive
governments relied on different sources to finance this gap, including foreign
inflows into Egypt’s stock and debt markets, withdrawing from international reserves
and support from the Gulf. But none of these sources proved sustainable, which
is why there is a crisis today.

3. Why has export
growth lagged import growth since 2008? To identify the source of the problem, assume
for the sake of argument that Egypt exported oil. Is the problem due to Egypt’s
exporting fewer barrels of oil (a volume issue)? Or is it due to lower oil prices
(a price shock)?

At least part of the
problem is due to exports volume, which has not only failed to keep up with
imports volume growth, but it has actually been declining since its peak in
2008 (see chart).

4. One way to quantify
the impact of declining exports volume is through a counterfactual analysis. This
is done by asking what would have happened to Egypt’s external balances if exports
volume had remained at the 2010 level, but everything else (export prices,
exchange rates, imports and transfers) had evolved as in the actual data.

Under the counterfactual
scenario, Egypt’s current account (the sum of trade balance and transfers from
foreign governments and Egyptians abroad) would have been in a surplus of 2.2%
of GDP in 2014 instead of a 2.0% deficit. Even if we exclude public transfers (mainly
support from the Gulf amounting to about $15bn in 2013-14), the current account
would have been in a slight deficit of 0.5% of GDP.

This suggests that
if Egypt had maintained its exports volume at the 2010 level, let alone succeeded
at growing it, it would have probably averted its ongoing currency crisis.

5. So why did exports
volume decline so much? Potential reasons include: First, slow growth in Europe—Egypt’s
main export destination—which reduced demand for Egyptian exports. Second, less
tourism due to the worsening security situation. Third, reduced traffic through
the Suez Canal due to the slowdown in global trade.

6. In conclusion,
reviving exports should be the main solution of Egypt’s currency woes. But this
is a problem that cannot be readily solved by a new central bank governor or monetary
policy. Certainly not on their own.

Sunday, 13 September 2015

There
is little evidence supporting the case for devaluing the currency in order to
promote exports in Egypt.

Talks intensified
last week about the possibility of devaluing the Egyptian pound. The Investment
Minister, Ashraf Salman, told a conference in Cairo that depreciation
may no longer be a choice. His colleague, the Minister of Industry and Trade, blamed a
strong pound for the recent dismal performance of exports. The latter’s
logic suggests that some devaluation of the currency could help Egyptian
exports and preserve the dwindling reserves. But is this true? Does currency
devaluation actually boost Egyptian exports?

Two considerations
are important in answering this question:

1. When it comes to
boosting exports, inflation
matters as much as the exchange rate. In theory, currency devaluation supports
exports by making them cheaper when expressed in a foreign currency. But the
gains from the exchange rate devaluation could be wiped out if the cost of exports increases
due to high inflation. This suggests using a measure of the exchange rate that
also takes into account changes in prices. This measure is called the “real
exchange rate”.

2. It is important
to look at broader measures of the exchange rate beyond the value of the
Egyptian pound against the US dollar. Nearly a quarter of Egypt’s trade was
with the Euro Area in 2014 compared to only 7% with the US. This means that movement
of the Egyptian pound against the euro is almost four times more important than
its movement against the dollar. To account for this, a broad measure of the
exchange rate against a basket of currencies can be constructed, with each currency
weighted by Egypt’s trade exposure to that country. This measure is called the
“effective exchange rate”.

The two
considerations suggest we should look at the “real effective exchange rate”
(REER) when we want to evaluate the impact on exports. Now, back to the
original question: is there a relationship between REER and export growth in
Egypt?

The chart above displays
the change in Egypt’s REER (on an inverted scale, positive values mean the
pound is appreciating) against the change in real net exports. If exchange rate
depreciation (red line moving up) drives export growth (blue line moving up),
then the two lines should move together. As the chart shows, there is a very
weak link between changes in REER and Egyptian exports growth. In fact, over
the period 2007 to 2011, the two lines were moving in opposite directions!

The authorities
consider imports and exports relatively inelastic to the exchange rate as exports are constrained by
non price factors and given the large share of wheat and intermediate inputs in
imports. Indeed, the large depreciations of the REER in 2003 were not followed
by a strong response in net exports.

This is what the
authorities believed then. Have they changed their mind now?

Tuesday, 25 August 2015

Things used to be
simple in the Iraqi economy. The government received large revenues from oil exports. The revenue trickled down to the rest of the population through
salaries to the large number of unproductive (and sometimes
non-existent) civil servants employed by the government, with corruption
taking a slice of the revenue as it moved down the pyramid.

But the world
changed in June 2014 as the war with ISIS intensified and oil prices tumbled
almost simultaneously. The government’s oil revenue fell by more than a half, and a
significant chunk of the reduced income had to be spent on financing the war
with ISIS.

The new reality
manifests itself most strikingly through the 2015 budget, where the government
is struggling to finance an increasing deficit.

The initial budget
law stipulated a
deficit of around 26tn dinar ($22bn). But things have not exactly gone
according to plan. Lower oil export volumes and delayed introduction of non-oil
taxes mean that revenues are likely to fall short of their budgetary target. Expenditure
is higher than anticipated as a $10bn payment to international oil companies was
not adequately included in the budget. But the government plans to make up for
this by cutting investment spending. As a result, the deficit is now likely to
reach 42tn dinar, or around 20% of GDP.

How is the
government going to finance this deficit? It intends to raise around 8tn dinar through
external borrowing. This includes borrowing from the International Monetary
Fund and the World Bank, but also involves plans to issue bonds in
international markets. Iraq has recently managed to obtain a credit
rating from Fitch for the first time (hint: not a good one), which could
facilitate its attempts to tap international bond markets.

But nearly half of
the deficit (19tn dinar) is expected to be indirectly financed by the Central
Bank of Iraq (CBI). This works as follows: commercial banks would lend the
government by buying its T-bills, then sell these loans to the central bank and
receive newly-printed money in exchange.

Getting the central
bank to finance the government’s deficit is dangerous and could have painful
implications for inflation and the value of the Iraqi dinar. And even with
this, the government still admits a financing gap equivalent to a third of its
deficit (13tn dinar) which it hopes to
fill with unidentified “domestic and foreign sources”.

The two shocks (oil
prices and the war with ISIS) are creating a messy reality in Iraq. And with oil
prices remaining low for longer, and the war with ISIS unlikely to end anytime soon,
the shocks may turn out to be less transitory than first anticipated. The
urgency of the situation could force a major overhaul in policy. But this remains
more of a hope than an expectation.

Monday, 17 August 2015

The consensus among
oil analysts was that 2015 would be a bad year for oil prices, but things
should improve after that. Their thesis was that lower oil prices would make
the business of high-cost US shale oil producers unviable, pushing some of them
out of the market. This should slow down the growth of oil supply, allowing
demand to catch up and prices to recover. The consensus is now changing, and
the reasons is: Iran.

Let’s take this
step by step. In 2015, oil markets are expected to be over-supplied by around
0.8m barrels per day (b/d), even if OPEC sticks to its production ceiling of
30m b/d. Consequently, oil prices should remain low—in the $50s range—during the
year.

How about 2016? US
shale is doing its bit to rebalance the market. The
US is expected to add only 0.3m b/d to existing production (compared to
0.9m b/d in 2015 and a whopping 1.4m b/d in 2014). As a result, demand growth
was expected to outpace supply growth by around 0.3m b/d, reducing inventories
and pushing up prices. This was the consensus before Iran.

Following the
agreement on its nuclear programme and the prospect of lifting economic
sanctions in 2016, Iran is expected to return to the oil market. Estimates vary
on how much additional oil Iran could produce once the sanctions are lifted,
but they range between 0.2-0.8m b/d. Whatever it is, it will almost certainly
wipe out the 0.3m b/d of excess demand which was expected to drive the recovery
in oil prices. With the return of Iran, inventories are expected to stabilise, or
even increase, and prices will continue being low (again in the $50s range)
into 2016.

In theory, Iran
should not matter for the oil market. After all, it is a member of OPEC and the
cartel has a production ceiling of 30m b/d. If Iran produces more, other OPEC
members should produce less to maintain the ceiling. But this is unlikely to
happen in practice: OPEC producers will probably continue pumping as much oil
as they can to meet their financial obligations in an environment of low oil
prices.

Monday, 10 August 2015

Weak
infrastructure, corruption and lack of fuel are behind the chronic power
shortage in Iraq.

The ongoing
protest movement in Iraq is developing fast and, judging by the list of reforms proposed by Prime Minister Haider Al-Abadi yesterday, is shaking up the political landscape. The
movement was triggered by power
shortage amid a scorching heatwave that is engulfing the country. It is a puzzle
why electricity remains in short supply more than 12 years after the fall of
Saddam. Iraq earned large financial windfalls from the oil price boom of recent
years, and directed a lot of resources towards investment in the electricity
sector. Iraq is also one of the world’s largest and fastest growing oil
producers, so it should not have trouble finding energy to operate its power
plants. So where is the problem?

There is a serious
shortage of electricity in Iraq. Demand for power in Iraq was estimated at 13.7
gigawatts in 2010, but supply fell well short at 8.3 gigawatts. This restricted
electricity supply to eight hours per day on average. The problem is clearly
one of insufficient supply rather than excessive consumption. Iraq’s electricity
consumption per capita (1,187 kilowatt hours) is much lower than countries
with similar income level such as Serbia (4,359 kilowatt hours) and South
Africa (4,581 kilowatt hour).

·What are the causes of the problem?

1. Weak and
inefficient infrastructure. Iraq’s nameplate power generation capacity in 2010
was 15.3 gigawatts, but it has one of the most
inefficient generation systems in the region. This meant that the maximum technical
capacity was 12.3 gigawatts. Shortage of water and fuel reduced production by 3
gigawatts, and aging by a further 1 gigawatt. Beyond generation issues, the
transmission and distribution infrastructure is very weak due to
under-investment and depreciation.

2. Widespread
corruption. Electricity projects require many signatures and approvals,
encouraging bribes and short-cuts at every step of the way. This slows down the
investment process, and results in the under-execution of capital budgets. So
although large allocations were made to the electricity sector, a big share were
returned unspent to the central government at the end of each year. Corruption
also comes in another variety: In 2011, the Ministry of Electricity signed
contracts for electricity generation with a company that was bankrupt and
another that did not even exist!

3. Shortage of fuel
feedstock supply. 37 out of 47 power plants operate on natural gas. Former
Prime Minister, Nouri al-Maliki, famously complained
on TV about importing gas-operated power plants, when Iraq had no gas to
supply them with. In reality, Iraq does not lack natural gas: large quantities
of associated gas are produced but then flared due to the lack of infrastructure
to refine and consume it. The government has therefore resorted to importing
natural gas from Iran, but there are issues with the stability of this supply
and the logistics required to transport it to the power plants.

The issues here are
structural and systematic. The problems of weak infrastructure, inefficient use
of resource, red tape and corruption take time to resolve. There have been many
false dawns and many broken promises. The World Bank report cites the Ministry of
Electricity projections of meeting all demand by 2014, which seems laughable
now. Abadi’s reforms include a
clause calling for coming up with “a set of measures to end the problems of
electricity production, transmission, distribution and tariffs within two weeks”.
To say this is unrealistic would be an understatement.

Monday, 13 July 2015

When
it comes to boosting exports, inflation matters at least as much as the
exchange rate.

The decision by the
Central Bank of Egypt (CBE) to let
the Egyptian pound depreciate was applauded by some
commentators. They argued that a weaker pound can boost exports by making
them cheaper relative to their competitors. However, even in theory, this
argument is incomplete and misses important ingredients. Careful analysis shows
that when it comes to boosting exports, inflation matters at least as much as
the exchange rate.

Let’s take an example.
Consider a situation in which Egypt and the US produce an identical good, which
they export to the rest of the world. Suppose that the price of the Egyptian
good is 100 pounds, and the price of the US-produced good is $100. Now, assume
that the exchange rate is such that 1 pound = $1. This means the price of the
Egyptian good in dollars is $100, exactly the same as the price of its American
counterpart. Consumers will therefore be indifferent between buying either.

Suppose that the
CBE then decides to let the pound depreciate by 10%, so that $1 = 1.1 pound. The
price of the Egyptian good is still 100 pounds, but its price in dollars is now
$91 (=100/1.1). Because the Egyptian good costs less than the American one
(which is sold at $100), consumers will choose to buy more of the Egyptian good
at the expense of the American one. This is exactly the argument that proponents
of the recent depreciation of the pound make.

Assume then that inflation
in Egypt is 20% but it is zero in the US. This level of inflation implies that
the Egyptian good now costs 120 pounds. This
is equivalent to $109 (=120/1.1). The Egyptian good is now more expensive than
the American one, which still costs $100. Inflation has basically wiped out all
the competitiveness gains from the currency depreciation.

What are the
lessons of this simple example?

1. Inflation is at
least as important as the exchange rate when it comes to making exports more
competitive in international markets. In other words, it is real exchange rate
(which also takes inflation into account) not nominal exchange rate that
matters for exports.

2. With Egypt
running double-digit inflation and most of the rest of the world operating at
below 2% inflation rates, the CBE has room to improve the appeal of Egyptian
exports by reducing inflation, not just the value of the currency.

Of course, these
conclusions are under the assumption that Egyptian exports respond to
improvements in price competitiveness (equivalently, a fall in the real
exchange rate)—an assumption that is not uncontroversial. But this is another story.

Monday, 6 July 2015

Paradoxically,
by aiming for a lower budget deficit, Egypt may hurt its growth prospects and
end up with a higher deficit than it is hoping for.

There was some last-minute
drama in the release of Egypt’s budget for the current fiscal year which began
on July 1. The president, Abdel Fattah al-Sisi, rejected the initial
budget that was presented to him. He asked the Ministry of Finance to reduce
the deficit, which was expected to reach 281bn Egyptian pound (9.9% of GDP). In
the space of a few days, the ministry re-evaluated its figures and came up with
a revised budget and a new deficit of 251bn pound (8.9% of GDP). These events
raise two questions: How did the ministry manage to reduce the deficit by 30bn
pound? And can the new deficit be realistically achieved?

The answer to the
first question is that revenues were revised up by 10bn pound while
expenditures were revised down by 20bn pound. As the table below shows, the
higher revenues are a result of higher non-tax revenues, which include profits
from publicly-owned companies, the central bank and the Suez Canal. Why are these
expected to increase by 10bn pound now compared to a few days ago? It is not
clear.

Meanwhile, half of
the expected cut in expenditure (10bn pound) is due to lower spending on salaries
and wages. The other half comes from either decreased purchases of goods and
services or lower spending on other items (which include defence, national
security and judiciary, among other things). The published figures do not allow
for a full distinction.

Now, can the new
deficit be realistically achieved? Probably not, and for three reasons.

Second, commodity
prices—whose decline in 2014/15 helped control spending and reduce the deficit—are
projected to rebound. The budget expects oil price to average $70 per barrel in
2015/16, up from the current price range of $55-$65. This is likely to increase
the burden on spending, making it harder to achieve the 8.9% of GDP fiscal
deficit.

Third, and most
importantly, the revised budget assumes that the lower deficit has no impact on
growth. The initial budget assumed a growth rate of about 5% in 2015/16—the same
growth rate assumed under the revised budget, even after slashing the deficit
by 1% of GDP. The assumption that the reduced budget deficit will have no
growth impact contradicts the recent experiences of the US, UK and the Euro
Area. In each of these regions, tighter fiscal deficits had a significantly negative
impact on growth, and these economies only picked up when the drag from fiscal
policy dissipated. One would not expect the experience of Egypt to be any different.

And there is a
feedback loop from lower growth to the budget: Slower growth could result in lower
tax revenues and a higher fiscal deficit, the very thing the Sisi’s revision to
budget sought to reduce. Paradoxically, by aiming for a lower budget deficit,
Egypt may hurt its growth prospects and end up with a higher deficit than it is
hoping for.

Monday, 29 June 2015

Egypt is rotating
its economic policy towards a new model based on two arrows: lower government spending
and higher investment. The move is prompted by Egypt’s backers in the Gulf—who
seem unwilling to continue writing blank cheques—and the unsustainability of
the old model—which saw the Egyptian government spending beyond its means. The
Egyptian authorities and the International Monetary Fund are optimistic that
the new model will lead to higher economic growth. And the latest numbers show
that at least one of the arrows is on track to hit somewhere close to its mark.

According to the
Ministry of Finance data, the budget deficit (the difference between the
government’s spending and revenue) for the period July 2014 to April 2015 was
9.9% of GDP. The Ministry expects the deficit for the whole fiscal year, which
ends on June 30, to reach 10.8% of GDP. This is quite a bit lower than the
2013/14 deficit, which was 12.8% of GDP, although still higher than the
original deficit target (10% of GDP).

The expected deficit
reduction will be achieved despite reduced support from the Gulf and the
postponement in the implementation of capital gains tax. The former, which fell
by $5.7bn compared to a year earlier, would have reduced the budget deficit by
1.9% of GDP if maintained at last year’s levels. The impact of the capital
gains tax is less significant: it would have only reduced the deficit by less
than 0.1% of GDP if it had been implemented.

So how was the
deficit reduction achieved? First, higher growth has resulted in higher tax revenue
for the government. Real GDP growth accelerated to 5.6% in the first half of
the current fiscal year compared to 1.2% in the same period a year earlier. As
a result, Egypt’s tax revenue increased by 22.6% over a year ago. Second, lower
food and energy prices have helped the government to control its expenses.

Going forward,
Egypt plans to continue tightening fiscal policy. The government has recently
announced the deficit target for 2015/16 (9.9% of GDP), and Egypt’s five-year
macroeconomic strategy expects the deficit to continue declining to 8.1% of GDP
in 2018/19. There are risks to this outlook. Not least because commodity prices
are expected to recover and may increase expenditure. In addition, too rapid a fiscal
consolidation can sometimes be self-defeating: it can be detrimental to growth
and hence to revenue and the deficit itself. But Egypt and its regional and
international backers are intent on continuing firing the fiscal arrow.

Monday, 27 April 2015

Ahmed
Chalabi’s campaign against the currency auctions is based on weak economics.

The currency
auctions continue to divide opinions in Iraq. The Central Bank of Iraq (CBI) is
appealing
before the Supreme Court against the imposition of Article 50 in the budget
law. The article, imposed by parliament, prevents the CBI from selling more
than $75m a day in the auctions. Meanwhile, Ahmed Chalabi,
the chairman of the parliamentary finance committee who is now spear-heading
the attack against the auctions, has claimed that they have been a source of corruption, which led to the depletion of the country’s reserves. Undeterred by
critics, the CBI has restarted the auctions on 6 April, after a few weeks’
suspension. Its daily sales averaged $133m in the first nine sessions, well
above the limit set by parliament. Who is right and who is wrong in this
debate?

1. On form alone, it was wrong to include Article 50 in the budget law. The budget law
should be about fiscal policy: the government’s expenditure, sources of revenue,
new taxes etc. Article 50, however, was about the conduct of monetary policy. It
can be debated whether it intrudes into on the CBI’s independence, but the
article was certainly out of place in a budget law.

2. Chalabi’s argument that the auctions were a source of corruption and
have wasted the country’s reserves might be right. Around a quarter of the dollars sold in the currency auctions in 2013 were not used for their intended
purposes, which is funding the private sector imports. But imposing a limit on
dollar sales is not the right response.

If Iraq wants to maintain its peg to the dollar and eliminate the black
currency market, it has no choice but inject enough dollars to meet demand.
Failing that, market prices would decouple from the official price, making the
peg redundant.

This is something that was confirmed time and again by Iraq’s recent
experience, and is happening now too. Although the CBI no longer publishes data
on the market rate, press reports suggest that the price of the dollar has reached 1340 as a result of the suspension of the auctions. This is 15% above the
official exchange rate and represents the highest deviation probably since the
data became available in 2004.

3. It may be argued that the official exchange rate itself should be
revised. Iraq may need to either devalue its currency by choosing a higher
price for the dollar or even let its currency float freely. Chalabi has hinted
at that in his interview, saying that “the price set by the central bank is its
choice and is not based on a particular rule”. This is a debate that could be
had, especially against the background of of lower oil prices. But as long as
Iraq wants to maintain its current peg and as long as it wants to eliminate the
need for an unofficial currency market, the CBI should to be allowed to supply
enough dollars without restrictions.

Tuesday, 14 April 2015

On 2 April, the
world’s major powers (the so-called P5+1) and Iran announced a
framework for a final agreement on Iran’s nuclear programme. The P5+1 are demanding
limits on Iran’s nuclear programme in exchange for lifting the sanctions which
have crippled the country and its economy. The impact that this announcement will
have on the oil market depends on three related questions: Will the
announcement lead to a lifting of the sanctions on Iran? How much will Iran
produce once the sanctions are lifted? And how will the extra Iranian
production affect oil prices?

Will the announcement
lead to a lifting of the sanctions on Iran?

The announcement
was far from being a final deal. It merely represented a set of parameters which
will form the foundation of the final agreement. Long and hard negotiations are
expected before the 30 June deadline, and “nothing is agreed until everything
is agreed”. But, a deal looks now more
likely than it before the announcement, if only because the framework
was more detailed than expected.

Sanctions, in
particular, remain a thorny issue. The framework suggests that sanctions will
be lifted only after “after the IAEA has verified that Iran has taken all of
its key nuclear-related steps”. This could take six months to a year after reaching
a final agreement, according
to John Kerry, the US secretary of state. So sanctions are unlikely to be
lifted until the first half of 2016, which runs contrary to the Iranians’
desire for their removal on the day of the agreement.

How much will Iran
produce once the sanctions are lifted?

According to the
latest estimates by the International Energy Agency, Iran has a spare oil capacity
of 0.76m barrels per day (b/d) which can be reached within 30 days. It is fair
to assume that Iran will try to produce and export the bulk of this spare
capacity once the sanctions are lifted.

How will the extra
Iranian production affect oil prices?

Useful lessons can
be drawn from the Libyan supply shock in 2011. In that episode, Libya’s
production declined from around 1.7m b/d to only 0.5m b/d resulting in a 25% increase
in oil price from mid-February to end-April 2011. Assuming that Iran will impact
the market proportionally but in the opposite direction, the additional expected
Iranian production will probably lower oil prices by 16% (=25%*0.76/1.2). This means
that the lifting of sanctions on Iran could depress oil prices by around $9. This
assessment is similar to that of the US Energy Information Administration, which
expects that additional Iranian production would
lower oil prices by $5-$15.

Conclusion. While there is still
a long way before a final deal with Iran is reached, the recent agreement on a
framework is an important step in that direction. Once a final deal is reached,
it could result in a lifting of the sanctions in the first half of 2016. This
would add 0.76m b/d of extra Iranian oil into the market, which could depress
oil prices by around $9.

Monday, 30 March 2015

The
impact of the conflict in Yemen on the oil market is likely to be limited,
unless it spreads outside its borders.

Oil prices jumped by
almost 5% when the Saudis launched
air strikes against Yemen on 26 March. The strikes have raised questions on
whether this could cause a significant supply disruption in the oil market. The
answer depends on how the conflict unfolds and how widespread it becomes. For
this, it is useful to consider three scenarios.

Scenario 1: The
conflict stays within the Yemeni borders. This is the most likely scenario. The regional
foes have tended to fight their wars through domestic proxies, as in the case
of Syria. The scenario promises Yemen years of chaos and misery, but is likely
to have little impact on oil prices. With a production of just 150 thousand
barrels a day (b/d), Yemen is a small producer accounting for less than 0.2% of
global oil supply. Any losses from the Yemeni oil production can be easily
replaced with the Saudi excess capacity. And in any case, the oil market is
ridiculously over-supplied, so a small loss will hardly be noticed.

Scenario 2: The
conflict spills over in a limited way. This could take the form of the
closure of the Bab el-Mandeb Strait. The strait is an important trade route, where 3.8m
b/d of crude oil and refined products passed through in 2013, mostly going
from the Gulf to the Mediterranean. But the closure of the Bab el-Mandeb Strait
does not take this supply out of the market; it just means that the oil tankers
have to use an alternative route around Africa. This would add time and transit
cost, but the impact on the oil market should still be contained.

In this regard, the
strait of Bab el-Mandeb is far less important than that of Hormuz both in terms
of oil flow (17m b/d in Hormuz versus 3.8m b/d in Bab el-Mandeb) but also in
terms of the availability of alternative routes to bypass each strait (there is
not enough pipeline capacity to bypass the strait of Hormuz, while alternative
routes exist to bypass Bab el-Mandeb).

The closure of the Bab el-Mandeb Strait is unlikely. There is a heavy presence of international warships in nearby waters as well as an American military base in Djibouti. And if necessary, the Egyptian, Saudi or even the Israeli navy could be deployed to keep the strait open.

Source: Energy Information Administration

Scenario 3: A
widespread regional war. This scenario is extremely unlikely. But if it did
materialise, it would represent a major shock to the oil market. At risk would
be a third of the world’s oil production. However, it is difficult to imagine
how an outright war can come about. After all, the regional powers have shown a
preference to fight their wars through local proxies and possibly by exporting
fighters rather than engage in a direct conflict.

Conclusion. The impact of the
conflict in Yemen on the oil market is likely to be limited, unless it spreads
outside its borders. The prospect of a regional spillover currently looks unlikely.
Perhaps realising this, oil prices declined sharply on the second day of the
Saudi strikes, reversing all the gains made on the previous day.

Monday, 9 March 2015

Lower
oil prices and confusing policies are starting to cause a dollar crunch in Iraq.

1. Iraq gets almost
all of its US dollars from the government’s sale of oil. To meet the private
sector’s demand for dollars (to pay for imports, travel and medical expenses
etc), the Central Bank of Iraq (CBI) holds daily auctions in which it sells
dollars to the private sector at the official exchange rate (1,166 Iraqi dinar
per 1 US dollar) as long as import receipts are provided.

2. The 2015
budget imposed a new restriction preventing the CBI from selling more than
$75m a day in its currency auctions. The imposed limit reduces the volume of
dollars available to the private sector by two thirds (daily volumes averaged $204m
in 2014). The limit was not in the initial
draft of the budget, but was later added by the parliament to prevent the
depletion of international reserves as oil prices declined, reducing the availability
of dollars in the economy.

3. The restriction on
the currency auction brings back memories of the dollar
crunch of 2013. Following the sacking of its governor, Sinan al-Shabibi,
the CBI significantly reduced the volumes of dollars on offer at the auction. As
a result, the market price of the dollar deviated from the official price. At
its peak, the dollar was sold at 1,292 dinar in the market, almost 11% above
the official price. But even during this episode, the volumes sold at the
auction were about double the new $75m limit.

4. Following the approval
of the budget, the CBI reduced the volume of the dollars sold in its daily auction
to an average of $80m—above the ceiling imposed by the budget, but much lower
than the $204m it sold daily in 2014. Unsurprisingly, the market price of the
dollar began to deviate from the official price. It reached 1,237 dinar to the
dollar on 19 February, 6.1% above the official price.

6. Why is the
currency auction so controversial? Its controversy led to the sacking of a
former CBI governor, the imposition of a limit on the auction’s daily sales and,
ultimately, its outright suspension. Opponents claim that the CBI was lenient
in selling dollars against fake import receipts. The dollars sold were then
used for speculation and sometimes smuggled out of the country.

Are these claims
right? Probably yes. My estimate of private sector imports of goods of services
in 2013 is $41bn, which is below the $54bn sold in the CBI’s auctions in the
same year. This suggests that some of the dollar purchases were indeed used for
speculation and probably smuggled out of Iraq.

7. But is
tightening the supply of dollars the correct response to this? Probably not. As
in 2013, supply restrictions will only lead to a decoupling of the market price
from the official price—a process that is ongoing now despite the CBI’s
insistence that it is only temporary.

Monday, 2 March 2015

Egypt’s
new strategy of less government spending, more investment and higher growth is
a little ambitious

The economy of
Egypt has slowed down considerably since the 2011 revolution. Annual real GDP
growth, the standard measure of economic activity, has averaged 2.1% in 2011-14
compared to 5.6% between 2004 and 2010.

Almost half of that
growth differential was due to a slowdown in investment. It is hardly surprising
that investors have been spooked by the political and legal uncertainty which
have followed the revolution. In the chart below, the contribution of
investment to real GDP growth over 2011-14 is reduced to a barely visible grey
strip below zero. The other half of the growth differential was equally split
between private consumption and net exports as the overall environment proved
detrimental to consumer sentiment and competitiveness.

Faced with this,
the government’s strategy was to increase public spending to shore up the
economy. As a result, the government’s contribution to annual real GDP growth
has increased a little in 2011-14 relative to 2004-10 unlike all the other
components.

But this strategy
is now reaching its limits. The government’s budget deficit in the fiscal year
2013/14 was 13.8% of GDP. Excluding grants from the Gulf, the deficit was a
massive 17.6% of GDP. This is very large and not sustainable for two reasons. First,
because domestic banks—which have lent out large sums to the government in
recent years—will eventually run out of liquidity. And second, because Egypt’s
Gulf backers are showing reluctance to continue writing blank cheques and are seeking a change in the direction
of economic policy.

The Egyptian
government is therefore moving to a new strategy, which is based on replacing
government spending with investment. In its latest
survey of the Egyptian economy (which is published for the first time after
a five-year pause), the International Monetary Fund (IMF) predicts annual real
GDP growth will average 4.5% over 2015-19 despite a significant tightening in government
spending. This is because the IMF expects investments to grow at annual rate of
6.1% over the same period, which is high but still lags the 2004-10 rate.

To achieve this,
the government has been designing and promoting large infrastructure projects. These
include the Suez Canal Regional Development project as well as preliminary plans
to build a large number of housing facilities and construct roads. The authorities
also aim to attract foreign investment and the forthcoming
economic conference on 13-15 March is one platform to advertise the new
strategy.

The new strategy is
sound in theory but has its risks. After all, the factors which have inhibited
investment post-2011 are still largely in place. Egypt needs to attract enough
investments not only to counteract the substantial cut in government spending,
but also to raise growth from its current levels. This might be a little
ambitious given its prevailing circumstances.

Wednesday, 11 February 2015

Iraq
might approach the IMF for help, just like it did in 2009 when oil prices fell

The Iraqi parliament
approved
the government’s 2015 budget on 29 January. Merely passing a budget is normally
an unremarkable event, except in Iraq where it was met with relief and jubilation.
After all, the country went through the whole of 2014 without a budget.

How does the new budget
fare? Starting with the broad figures: Government revenue is expected to be
around 94.0tn Iraqi dinar ($80.7bn); expenditure is budgeted to reach 119.6tn
dinar ($102.6bn) resulting in a fiscal deficit of $21.9bn. A portion of the
deficit will be financed externally (around $8.3bn) with the rest financed through
domestic borrowing and the issuance of bonds. The broad picture hides two
problems, at least as far as raising the required $8.3bn of external financing
is concerned.

2. The budget
suggests borrowing $4.5bn from the IMF to finance the deficit. Problem: This
can probably only happen if Iraq agrees a programme with the IMF. An IMF
programme would imply conditionality, most likely starting with cutting
government expenditure.

Now we can blame declining
oil prices for Iraq’s fiscal predicament, but Iraqi policymakers do not seem to
have learnt from past mistakes. Iraq did rush to seek the IMF’s help last time
oil prices fell sharply in 2009. That programme was
a failure as the subsequent recovery in oil prices weakened the appetite
for reform in Iraq.

Rather than
learning from this experience by building up reserves during the oil boom
years, Iraq has managed to blow most of its savings. Reserves at the Development
Fund of Iraq (DFI)—whose role is precisely to accumulate oil surpluses in the
boom years to finance deficits in slumps—declined from almost $23bn in March 2013
to an estimated $4bn in November 2014. This drawdown would have been enough to
finance most of the deficit this year. Why did the government tap the DFI at a
time when oil prices were so high? No one knows. Conveniently, by the way, the
DFI has stopped publishing its balances since March 2014!

So after four years
of record high oil prices, Iraq remains fragile. All it took was a quick drop
in oil prices (which has not even persisted yet) to make Iraq consider seeking the
IMF’s help, just like it did in 2009/10. But while 2009 might have been a tragedy,
2015 looks more like a farce.

Search This Blog

Follow by Email

About Me (Ziad Daoud)

I am an economist currently based in the Middle East. I have previously worked for an asset management firm and, before that, I did a PhD at the London School of Economics. The views in this blog are solely my own.